Remuneration and share plans update
1. CEO: employee pay ratio reporting requirement – A closer look
For financial years starting on or after 1 January 2019, companies will be required to comply with a number of additional executive remuneration reporting obligations. Most of these derive from the Companies (Miscellaneous Reporting) Regulations 2018, which amend the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) (as amended, the Regulations). The most headline-grabbing of these additional disclosure requirements is the CEO: employee pay ratio reporting. In this note, we take a closer look at what companies will now need to do.
In 2016, the then-Home Secretary, Theresa May, announced the government’s intention to require companies to disclose the ratio of CEO pay to employee pay when she called for “responsible capitalism” and curbs to excessive executive remuneration.
Three main factors prompted this proposal. First, a political need to address growing public concern that executive pay was outstripping corporate performance (a concern fuelled by the events of the 2007/2008 global financial crisis). Secondly, increasing complexity around executive pay rendering pay packages increasingly opaque. Finally, a perception that remuneration committees were not paying proper attention to shareholder sentiments on executive pay and were failing to consider wider workforce pay when setting board pay and benefits.
Since 2013, companies based in the UK have had to disclose the percentage change in CEO pay and group employees’ pay from the previous year. This approach had been criticised as being too lax. For example, companies were able to choose to use senior employee pay only to produce more favourable results. The Regulations have now tightened these requirements.
What do the Regulations require companies to do?
The ratio obligation
A company must calculate and publish the ratios of the CEO’s total remuneration to the remuneration of each of the 25th, median and 75th percentile employees of the parent company (the ratios).
The ratios must be published in the annual directors’ remuneration report, in a prescribed table (the pay ratios table), building up to a 10 year history (such that a company’s 2029 remuneration report published in 2030 will be the first which can omit the 2019 ratios). Companies may voluntarily choose to keep more than 10 years of ratios in their pay ratios table.
Calculating the ratios
The CEO’s total remuneration is to be taken from the “total” figure in the single figure table in the company’s remuneration report.
This single figure table must show the total: (i) salary and fees; (ii) taxable benefits; (iii) single year performance-related remuneration; (iv) multiple year performance-related remuneration; and (v) pension-related benefits (together remuneration).
There are three methodologies to choose from when identifying employees’ remuneration. Companies must justify the option they select.
- Option A requires companies to calculate the pay and benefits for all UK employees. The starting point is to use the same methodology used to calculate the CEO’s single figure remuneration. Although this is the most statistically straightforward method, it is the most onerous because of the amount of data required.
- Option B requires companies to use the most recent gender pay gap information (GPG) to identify the pay and benefits of employees in the 25th, median and 75th percentile. For companies with GPG data, this may be attractive as it will result in consistency but adjustments to GPG data (for example extrapolating from hourly to monthly pay) must be fully explained.
- Option C allows companies to use any recent pay data: GPG, PAYE records, audited accounts, or salary review figures, to reach a final figure. Although this is the most flexible option, it will require the greatest amount of explanation from the company.
A key issue for companies is to determine who exactly is an “employee” within the meaning of the Regulations. The Regulations define UK employees as persons under a contract of service, except for those employed to work wholly or mainly outside of the UK. Companies will need to decide (using general employment law principles) whether zero-hours workers, agency workers and contractors are employees for these purposes.
The “narrative” obligation
Although many have fixated on the ratio obligation, the Regulations also require commentary to accompany the ratios. Companies will be expected to explain changes in the ratios, as well as any emerging trends. Companies will also be expected to comment on whether the ratios are consistent with the company’s wider policies on employee pay, reward and progression. Companies will need to consider carefully any internal messaging as well as dealing with external perceptions and the impact of the market in which the company operates. It is not inconceivable that the published ratios may lead to unfair comparisons of companies in different sectors and of different sizes.
Directors who knowingly do not comply with these obligations, or are reckless as to their compliance, will be committing an offence.
Which companies need to disclose the ratios?
There are two successive tests. First, a company must be a UK-incorporated company listed on the London Stock Exchange, an exchange in the European Economic Area, the New York Stock Exchange or NASDAQ (such a company being a listed company). Companies listed on the Alternative Investment Market are outside scope.
Secondly, a listed company must average 250 UK employees per month, calculated using the aggregate of the headcounts for each month over the course of a year divided by 12, (the 250 employee requirement). There are complex rules which govern the 250 employee requirement. If the listed company is a parent company, the number of UK employees within group companies must be included too, and pay ratio information must relate to the group not the company. Even when a company ceases to meet the 250 employee requirement, the obligation to report will endure for a further year.
Emerging trends 1
In the 2019 AGM season so far, 80 companies out of 221 FTSE 350 companies (36%) have made voluntary CEO pay ratio disclosures (44 FTSE 100 and 36 FTSE 250). Of these 80 companies:
- 75 companies disclosed the ratio of the CEO’s pay to the median employee’s remuneration, four companies disclosed the ratio by reference to the average of employees’ remuneration only, and one company made no disclosure as to how the ratio was calculated; and
- 68 companies (33 FTSE 100 and 35 FTSE 250) voluntarily disclosed the ratio of the CEO’s pay ratio to the remuneration of the 25th and 75th percentile employees.
For median employees, ratios ranged from 9.3:1 to 813:1. The majority of companies (just over half) used the Option A methodology.
In recent times, fairness and equality have been major political themes. Inevitably, the ratios will form part of this discourse. We anticipate that the ratios will be reviewed carefully by all stakeholders. It is not inconceivable that companies that currently fall outside the disclosure rules may, at the behest of investors, be expected to comply on a voluntary basis. Whether the ratios will lead to unfair and unhelpful comparisons between companies in different sectors and of different sizes remains to be seen.
2. New financial services remuneration rules - CRD V is published
On 20 May 2019, the European Council formally adopted the final text of the Capital Requirements Directive V (CRD V). Member States now have until 1 January 2021 to transpose CRD V into national law. The European Banking Authority (EBA) will issue new guidelines on sound remuneration policies providing more detail on how the new rules should be interpreted and applied in practice.
CRD V amends the rules in CRD IV which, amongst other things, introduced a number of additional remuneration rules designed to curb excessive risk taking within banks, credit institutions and investment firms. Once in force, CRD V will generally apply to credit institutions and bank-like investment firms.
Separately, new remuneration rules for investment firms have been proposed by the Commission as part of its Investment Firm Review (IFR). Although these rules are still progressing through the EU legislative process and so are not yet in final form, the intention is that the investment firm rules will operate alongside CRD V. In essence, the IFR rules are expected to remove most investment firms from the scope of CRD V and so take them outside of the ambit of the more onerous rules like the bonus cap.
Here are some of the headline changes coming out of CRD V:
- Bonus cap - The bonus cap (i.e. the 1:1 fixed to variable remuneration ratio, or 1:2 with shareholder approval) will apply to all firms that are subject to CRD V. Currently, in the UK, proportionality level three firms (i.e. firms with total assets of less than £15bn) can disapply the bonus cap. This tiered proportionality approach adopted by the UK will disappear under CRD V which means that an additional c.200 UK firms will have to apply the bonus cap irrespective of their size.
- Proportionality - Under CRD V, deferral, retention and payment in instruments (typically known as the “pay-out process” rules) will apply to all firms. This means that, in the UK, proportionality level three firms will no longer be able to disapply the pay-out process rules unless they fall within a new and narrower exemption only applicable to small and non-complex firms with assets of less than €5bn over a four-year period. The new rules do provide that a Member State may set a higher asset threshold (up to €15bn) if it considers it appropriate. It will be interesting to see if the UK takes advantage of this discretion so as to narrow the gap between the existing €15bn threshold and the new €5bn limit. In addition, the pay-out process rules can be disapplied in respect of individual material risk takers (MRTs) whose annual variable remuneration does not exceed €50,000 and does not represent more than a quarter of total remuneration. Currently in the UK, the individual MRT threshold is £500,000 and a third of total remuneration and so the new rules represent a significant narrowing of the exclusion.
- Deferral - Currently under CRD IV, variable remuneration must be deferred for a minimum period of three to five years (with vesting no faster than on a pro-rata basis). Under CRD V, the minimum deferral period is extended to four years, or five years in the case of senior managers. The UK has “gold-plated” the existing CRD IV deferral requirements such that all MRTs must defer for a minimum of three years and certain risk managers and senior managers must already defer for a minimum of five and seven years, respectively.
- MRTs - MRTs are currently determined by reference to the definition in the Regulatory Technical Standards issued under Article 92 of the Capital Requirements Regulation. Going forward, the definition will be set out in CRD V and MRTs will include all members of the management body and all senior management and individuals who receive remuneration of €500,000 or more or whose remuneration is higher than the average remuneration awarded to senior management.
- Consolidation group companies - Where subsidiaries within a CRD consolidation group are subject to other specific EU remuneration requirements, they are currently required to apply the more stringent CRD IV rules as a consequence of being part of the consolidation group. This can put some firms at a disadvantage when competing with other similar firms that are not part of a CRD IV consolidation group. This issue is now being addressed. Consequently, CRD V provides that its remuneration rules will not apply to a subsidiary which is subject to other EU remuneration rules, e.g. the new IFR remuneration rules.
- Share-linked instruments - Listed firms will be permitted to use share-linked instruments that track the value of shares to meet the payment in instruments requirement. Under the current rules, only unlisted firms are permitted to use share-linked instruments. Listed firms were required to use shares which, in some cases, resulted in considerable administrative burdens and costs.
3. Responses from government to the BEIS report
The UK government has responded to recommendations on reforming executive pay made by the Business, Energy and Industrial Strategy Select Committee (a committee of the UK parliament) in March this year. The key points coming out of the government’s response are as follows:
- the new Audit, Reporting and Governance Authority (the ARGA), which will replace the Financial Reporting Council (FRC), will be responsible for monitoring companies’ remuneration reports and Section 172(1) statements (statements of how their directors have satisfied their duty to promote the company’s success). This will form part of an expanded and strengthened corporate reporting review regime;
- the government disagrees with the Committee’s recommendation to require at least one employee representative on a company’s remuneration committee. Although the government is aware of some companies that have started inviting employee representatives to remuneration committee meetings, it says this method may not be suitable for all companies;
- the government does not intend to expand the current CEO pay ratio reporting requirements to all companies with more than 250 employees (rather than simply quoted companies). It wants to monitor the impact of the new requirement when reporting first begins in 2020 before considering extending the requirement to other companies; and
- finally, it has rejected the committee’s recommendation that all remuneration committees set an “absolute cap” on executive pay. The government say it is for individual remuneration committees to decide whether to set a cap on remuneration pay-outs and for shareholders to have their say through binding votes on the company’s remuneration policy.
The government has also published a new Q&A document explaining recent changes to the directors’ remuneration reporting regime that came into effect on 10 June 2019. For more information on these changes, see our previous Corporate Law Update.
4. Updated GC100 Directors’ Remuneration Reporting Guidance 2019
10 June 2019 marked the deadline to transpose the Shareholder Rights Directive II (the Directive) into national law. In the UK, this was achieved by amending the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (as amended, the Regulations). The General Counsel 100 group (the GC 100) has published its fourth version of the GC 100 Directors’ Remuneration Reporting Guidance 2019 (the Guidance) in light of the amended Regulations. The key amendments are as follows:
- Substance over form approach relating to identification of director
A CEO or deputy CEO (however described), is to be treated as a director regardless of whether or not they have been appointed as directors. Where a company has not appointed a CEO or deputy CEO as a director, the intention of this provision is to ensure that the most appropriate person is captured by the reporting requirements. This person may be the most senior member of the company’s executive committee. This “expansive” approach to individuals covered by the Regulations will only be relevant for future reporting.
- Expansion of pay ratio requirements to all directors
The percentage change of each director’s (executive and non-executive) salary or fees, benefits and short-term incentives (as found in the single figure table) must be compared against the average of full-time employees of the parent company. The percentages must show historic information for the past five years. Previously this requirement applied only to a company’s CEO, but now it extends to all directors (executive and non-executive).
- Rules relating to deviation from remuneration policy
In future remuneration policies, a company must explain the “decision-making process” for determining, reviewing and implementing the policy. In addition, the company will need to explain, in the remuneration report, any deviations from its stated implementation procedure. Historically, companies have not had to state an implementation procedure in their remuneration policy (and generally have not done so). Where the policy does not set out an implementation procedure, it will not be possible to explain any deviations from it in the report.
- Disclosure of length of duration of director’s service contract
There must be an indication of the duration of directors’ service contract or arrangements in the remuneration policy – with companies either providing the term length of directors’ contracts (if they are fixed term) or stating that no term exists (if they are not fixed terms, this latter being more common employment practice in the UK).
It is telling that the guidance – as it has done for at least the past two iterations - gives pride of place to three principles: “flexibility, discretion and judgement” and should not change the outcome-driven approach to directors’ remuneration firms are encouraged to adopt.
5. HMRC publish 2017-2018 tax-advantaged employee share plans statistics
HMRC has published its latest statistics from the financial year 2017-2018 on the use of tax-advantaged employee share plans. Key findings include:
- the number of companies operating a tax-advantaged employee share plan has increased by 12%, continuing the long-term increasing trend. This coincides with the increase in the number of companies operating EMI plans, suggesting that EMIs have driven much of this growth;
- the number of companies with the remaining three plans (SIP, SAYE and CSOP) has declined by 9% over the period from 2007-2008, with much of the decline attributable to CSOP, while by comparison the SIP numbers have remained relatively constant;
- the estimated annual cost of providing income tax and National Insurance Contributions (NICs) relief for the four plans in total is around £805m (£500m income tax relief and £305m NICs relief). This represents a decline of 13% from 2016-2017; and
- HMRC has postulated that companies’ predilection towards EMI plans is based on the £250,000 cap on value transferred to individuals over a three-year period (which provides significantly higher tax-savings than those offered under the SIP, SAYE and CSOP plans).
For reference see HMRC statistics.
6. EU Prospectus Regulation now in force
As we reported in our Spring Update, the new EU Prospectus Regulation came into force on 21 July.
Aside from levelling the playing field as between listed companies within the EU, the new Regulation also allows listed companies from outside the EU to offer their share plans to employees in the EU without first having to produce a prospectus. For this reason, many non-EU companies that operate share purchase plans have been eagerly waiting for the Regulation to come into force. From now on, such companies will be able to rely on the share plan exemption within the Regulation and not have to worry about falling within some of the more narrow exemptions based on value of shares offered or number of offerees. The new Regulations would also allow UK listed companies to be able to continue offering their share plans into the EU once the UK has left the EU.
If you would like to read more about the EU Prospectus Regulation and what it means for UK and non-UK companies, please see our article in the Spring Update.
Key dates in remuneration and share plans 2019/2020 calendar
|31 October 2019||UK to leave the EU (potentially with no deal) if the withdrawal agreement is not ratified by this date|
|8 November 2019||ESOP Centre/STEP Guernsey Share Schemes and Trustee Seminar (Guernsey)|
|20 November 2019||GEO’s Pan European Regional Event (Berlin)|
|4 December 2019||ProShare Awards and Annual Dinner|
|1 January 2020||UK-incorporated companies must start reporting their CEO pay ratios|
|10 January 2020||Deadline for UK implementation of Fifth Money Laundering Directive (including registration of employee benefit trusts)|
1 Source: Practical Law Corporate: Annual reporting and AGMs: emerging trends from the 2019 AGM season